What is the House Money Effect
The house money effect explains the tendency of investors and traders to take on greater risk when reinvesting profit earned via stocks, bonds, futures or options than they would when investing their savings or a portion of their wages.
Richard H. Thaler and Eric J. Johnson of the Cornell University Johnson Graduate School of Management first defined the “house money effect,” borrowing the term from casinos. Similarly, a gambler who continues to let the chips ride after a significant gain is said to be playing with house money.
BREAKING DOWN House Money Effect
The house money effect suggests, for example, that individuals tend to buy higher-risk stocks, bonds or other asset classes after profitable trades. For example, after earning a short-term profit from a stock with a beta of 1.5, it’s not uncommon for an investor to next trade a stock with a beta of 2 or more. This is because the recent successful outcome in trading the first stock with above-average risk temporarily lowers the investor’s risk tolerance. Thus, this investor next seeks even more risk.
Windfall trades sometimes bring on the house money effect. Say an investor more than doubles her profit on a longer-term trade held for four months. Instead of next taking on a less-risky trade or cashing out some proceeds to preserve her profit, the house money effect suggests she may next take on another risky trade, not fearing a drawdown as long as some of her original gain is preserved.
Longer-term investors sometimes suffer a similar fate. Say an investor in a growth-oriented mutual fund earns more than 30% in a year’s time, largely driven by very strong market conditions. Keep in mind, the average stock gain tends to be roughly 6% to 8% a year. Now say this investor leaves the growth-oriented fund at year’s end to next invest in an aggressive long-short hedge fund. This may be an example of the house money effect temporarily lowering the investor’s risk tolerance.
For longer-term investors, one of two courses of action tend to be preferable to the house money effect: Either staying the course and maintaining a steady risk tolerance, or becoming slightly more conservative after big windfalls.
Of note, the house money effect also carries over to company stock options. In the dot-com boom, some employees refused to exercise their stock options over time, believing it was better to keep them and let them triple, then triple again. This strategy significantly stung workers in 2000, when some paper millionaires lost it all.
The House Money Effect vs. Letting Winners Ride
A technical analyst tends to draw a distinction between the house money effect and the concept of “letting winners ride.” To the contrary, one way technical traders manage risk is by cashing out half the value of a trade after meeting an initial price target. Then, technical traders tend to move up their stop before giving the second half of the trade a chance to meet a secondary price target.
Many technical traders utilize some version of this practice, in an effort to continue to profit from the minority of trades that continue to move up and up, which still holds to the spirit of letting winners ride while not falling victim to the house money effect.